In Defense of the Fed's Independence

This guest post was filed by David Zaring, University of Pennsylvania professor and a blogger at The Conglomerate.

Yesterday, Federal Reserve Vice Chairman Donald L. Kohntestified before Congress on the independence of the Fed, heretofore the most independent of all federal agencies and the one least subject to congressional oversight.

Might that independence be altered by the coming financial reform legislation? There are two challenges before Congress to Federal Reserve independence, and it will be tricky for the Fed to manage them both in a way that preserves its independence, even though that independence has, for the most part, been a good thing.

Why is the Fed so independent? Part is statutory – the Fed has a great deal of flexibility in setting monetary policy, and Congress wrote its governing legislation to give it that flexibility. Part of it lies in the controversial (for a whiff of the controversy, see the dissent in this potential blockbuster of a case, which the Supreme Court will review next year) fact that Fed governors essentially cannot be fired, by the President or anyone else.

But part of it is based on the fact that the Fed does not rely on Congress for much of its budget. Rather, it pays for its operations from fees it receives from its member banks. A flexible remit from Congress plus separation from legislative purse strings plus very strong job security combine to make the central bank powerfully insulated from political control, and the Fed has guarded that independence by operating secretively, giving rise to a culture of opaqueness that would never be tolerated at, say, the Environmental Protection Agency.

This independence is, as Kohn noted in his testimony, not necessarily a bad idea. He observed:

Operational independence -- that is, independence to pursue legislated goals -- reduces the odds on two types of policy errors that result in inflation and economic instability. First, it prevents governments from succumbing to the temptation to use the central bank to fund budget deficits. Second, it enables policymakers to look beyond the short term as they weigh the effects of their monetary policy actions on price stability and employment.

But regulatory reform could affect independence in two ways. First, giving the Fed new powers to police systemic risk will force it to work with other regulators and deal with more financial institutions, pulling it out of the "black box" of setting monetary policy and into the more accountable world of financial supervision. (It does some of this already; the question is whether it should do more of it.) Should that be matched with more congressional oversight over its systemic-risk responsibilities?

Kohn pooh-poohed this idea, but essentially, he wants to keep the Fed just as insulated from oversight by Congress while doing new work – regulation, this time of systemically important institutions – that other financial regulators do with more vigorous legislative control. Whether you think that is a good idea depends on whether you think the Fed is an institution in thrall to its member banks or is the smartest of our regulators. In my view, the Fed’s people are pretty smart.

The other reform proposal on the table is to subject the Fed to audits by the Government Accountability Office. The GAO has done a lot of work on TARP and even the Fed’s own efforts to pour liquidity into the troubled financial system. If the GAO helps Congress keep an eye on these programs, shouldn’t it keep an eye on everything the Fed does, including monetary policy?

Kohn wants the GAO as far away from the Fed as possible, and his testimony today was designed to parade a few horribles around with regard to Fed independence. The GAO might leak market-damaging information if it gets too involved in Fed supervision, he observed, and the markets will not like a congressional investigatory arm sniffing around monetary policymaking.

In disputing GAO oversight, he is probably also right. The Fed is an independent agency like no other, but it worked closely with two Treasury secretaries during the financial crisis, which suggests that Fed independence has not become Fed unresponsiveness. Moreover, the Fed is much less opaque now than it was before Alan Greenspan headed the bank – it publishes the minutes of its Open Market Committee and has fought to make its international initiatives more transparent.

It may be frustrating for Congress to be asked to give the Fed still more power, in exchange for much less oversight than it would get for anyone else. But the Fed has earned some trust here.

-- David Zaring is an assistant professor of legal studies at the University of Pennsylvania's Wharton School of Business. He also blogs at The Conglomerate.